The widening and deepening fallout from the US subprime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF`s latest Global Financial Stability Report (GFSR). At present, the issuance of most structured credit products` instruments that pool and tranche credit risk exposures in various ways` is at a standstill and many banks are coping with losses and involuntary balance expansions, the April 2008 report said. The report examines this and other forces that could push the current credit crisis into a full credit crunch, as well as offering policy recommendations to mitigate the impact.
``Financial markets remain under considerable stress because of a combination of three factors,`` said Jaime Caruana, head of the IMF`s monetary and capital markets department. ``First, the balance sheets of financial institutions have weakened; second, the deleveraging process continues and asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth,`` he added.
The first policy priority is to limit the spread of dislocations to other markets and to repair banks` balance sheets. Systemically important financial institutions need to move quickly to raise equity and medium-term funding, even if it is more costly to do so now, in order to boost confidence and avoid further undermining of credit channels. Although various investors, including sovereign wealth funds, have recently made capital infusions into banks, more such funding will likely be needed to recapitalize institutions.
Further, more rapid and informative disclosure of financial institutions is needed, and national authorities should seek to quell misperceptions by providing timely and accurate aggregate information.
The GFSR proposes that central banks and other relevant regulators issue special financial stability reports that could act to calm markets. Restoring counterparty confidence is a key element to reducing volatility and the knock-on effects to the real economy.
It is now widely acknowledged that public measures are needed in a number of areas. In particular, there may be a need to shore up the prices of various types of securities to prevent fire sales. Plans that use public money, however, should attempt to ensure that shareholders accept the first losses. Also, measures will need to carefully weigh the legitimate issues of consumer protection and the legal rights of contract holders.